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Once upon a time, big US companies provided their longtime employees with clearly defined pension benefits that guaranteed them enough to live on for the rest of their lives.
That fairy tale ending disappeared for many Americans in the 1980s, when most new employees started to be shunted into a new retirement option. Known as defined contribution plans, or 401k schemes, they put the onus on employees rather than leaving companies on the hook for future payments. Workers must set aside money to get an employer match and then manage their own funds through volatile markets.
Thirty-plus years on, as those workers approach retirement, the results are not looking pretty. The typical Gen X household has just $40,000 saved for retirement, and 40 per cent of their 401k plan balances are zero. Even those who have been able to save more got a stark reminder of the risks involved in 2022, when falling equity and bond markets slashed the average retirement plan balance by 20 per cent.
Pension experts agree that in general, DB plans produce better outcomes for workers because the funds are professionally managed and can balance long-lived workers with early deaths, while individual 401k participants have to worry about outliving their funds.
That’s why it is so intriguing that change may be on the way. Last month, IBM reopened its long-closed defined benefit plan to new participants. Other companies are considering following suit. They should, out of enlightened self-interest.
The change, like so many other things, is due largely to higher interest rates. These have sharply reduced the estimated cost of providing future payments, leaving many plans with a surplus that can only be used for pension benefits, on pain of hefty penalties.
Hence IBM’s creative solution. Its frozen plan had $3.6bn more in assets than liabilities at the end of 2022. It intends to use that surplus to offer new DB benefits to current employees instead of a 401k match that comes out of ordinary company income.
IBM’s plan was particularly well funded but it is not a one-off example. The average top 200 US corporate pension fund now has 105 per cent of the assets needed to fund its benefits, the highest ratio in 15 years, according to BlackRock, which has urged its corporate pension clients to consider reopening their plans.
Nearly half of large US employers still sponsor a DB plan, though only 21 per cent are open to new hires, according to consultancy Mercer. It recently surveyed chief financial officers and found that 65 per cent of other big companies with residual pension plans have considered reopening them and 88 per cent would do so if they could reduce their concerns about risk.
Should interest rates go back down sharply, today’s surpluses would turn into liabilities. That’s a big driver of a parallel trend in the other direction that has seen a record number of US companies paying to offload their closed pension plans to insurers while rates are high.
However, there’s a newish option that solves this. Market-based cash-balance plans pool resources and offer the option of payments for life like a traditional pension, but the final payout is based on the plan’s investment returns, limiting the employers’ exposure. On the plus side for employees, each participant gets a personal account and can opt for a lump sum at retirement instead of a regular payment.
To my mind, this is the best solution to date, as it shares the market risk while also giving employees an account balance they can check and control. Ideally, employers would follow IBM’s example by offering a supplemental 401k plan to allow employees to put in pre-tax dollars and benefit from long-term equity market growth.
Pension plans help good employers differentiate themselves in what remains a tight labour market in many sectors. They also make it easier to manage people out when necessary, a crucial advantage at a time when many companies are top-heavy with older employees. Fewer workers will cling to their jobs for fear that they cannot afford to retire, freeing up positions — and cash — for promotions. Topping up a pension plan is also a tax efficient way to induce departures.
Workers who understand pensions value the benefit: the United Auto Workers union has been trying for years to get its traditional plan reinstated for younger workers, and surveys show that public sector workers, who tend to have defined benefit plans, cite pensions as a key reason they stay on the job. Providing better retirement options makes good business sense.